Eric Falkenstein

Best way to find alpha currently, is to see what alpha was like in the past

Current alpha, as obvious as shown here, I, nor anyone else, would show you

Outsiders could not arbitrageBid-ask too largeNo way to see real-time prices

Barriers to entryEphemeralIn the early 80’s, pit traders could make

$100k+ arbitraging put-call parity

Call(strike=k) + K = Put(strike=k) + Stock

Since the payoffs are the same, the price must be the same. Thus, in terms of prices,

Call(strike=k) + K = Put(strike=k) + Stock

If C<P+S-K, buy C, sell restIf P<C+K-S: buy P, sell rest

Arbitrage: certain profit if held to maturity of call and put

Convexity adjustment to forwardsForward=e-rt(f-k)Futures=a*(f-k)f (forward) correlated with r (discount rate)Ho-Lee adjustment

2

1 1 90

2

2

0.009.0441 .0421 7 7.25

2

fwddaysfut fwd t t

5/1/2009 Futures Forward ConvBias6/17/2009 0.95 0.94 0.009/17/2009 1.01 1.01 0.00

12/17/2009 1.23 1.22 0.003/17/2010 1.34 1.34 0.006/17/2010 1.58 1.58 0.009/17/2010 1.84 1.83 0.01

12/17/2010 2.15 2.14 0.013/17/2011 2.40 2.38 0.026/17/2011 2.67 2.65 0.029/17/2011 2.91 2.88 0.03

12/17/2011 3.14 3.11 0.033/17/2012 3.30 3.25 0.046/17/2012 3.44 3.39 0.059/17/2012 3.56 3.50 0.06

12/17/2012 3.69 3.62 0.063/17/2013 3.74 3.67 0.076/17/2013 3.82 3.74 0.089/17/2013 3.90 3.81 0.09

12/17/2013 4.00 3.91 0.093/17/2014 4.04 3.94 0.106/17/2014 4.10 3.99 0.119/17/2014 4.18 4.05 0.13

12/17/2014 4.23 4.10 0.133/17/2015 4.25 4.11 0.146/17/2015 4.28 4.13 0.159/17/2015 4.32 4.16 0.16

12/17/2015 4.38 4.21 0.173/17/2016 4.39 4.21 0.186/17/2016 4.41 4.21 0.20

CB=Bond+option at stock price K-call by issuer at interest rate I

CB=Bond+Option100=8% Bond + 38% Vol Option=7%Bond +

45% vol OptionVolatility in option about 8% below ‘actual’

volatilitySpread about 50% above actual volatility

CFOs don’t mind selling options cheap

1994-03

AnnRet 10.3%

AnnStdev 4.5%

Sharpe 1.26

2003-08

AnnRet -7.8%

AnnStdev 12.6%

Sharpe -0.81

Good times, good times…Party over

Pair: Coke and PepsiGo long Coke if Pepsi goes up, but not CokePeople made millions, simple strategy ex post

Remove 1% in annual expenseDon’t alter gross expected returnLower volatilityGrowth to 20% of market: Index Mutual

Funds, ETFs, aboutLots of Alpha hereTough sell, though. Bogle had a tough time.

Generally, anything where you can measure inputs and define outputs, with enough data is done better by computersMarket makingUnderwriting credit

Example. FICO scoresDelinquencies, Past defaultsLength of credit historyAmounts owedLines outstanding

Take a half day to analyze

Create a database, create modelEasy to screw up

Ed Altman, Loan Pricing Corp, S&P not able to make a model though they had opportunity

Moody’s RiskCalc works, is profitable

Finance is about intermediation, savings to investors

Directing a set of savers, or investors, gives you power, responsibility, and thus value

Regular Business wilesHelpful, discrete, coalitions, competent,

energy, etc.Helps to know alpha, which is the final product

Value comes from Brand, reputation, connections, regulations,

scale efficiencies, scope efficiencies, an incurious or limited competence from customers, a secret process, inimitable excellence

Don’t ask someone you don’t know very well what their value-add is an expect an honest answer

In the standard model, risk taking in admired ex ante, not rationally regretted ex postExample: 50-50 chance to win $2 or lose $1When you lose, it is unfortunate, not stupid

In reality, risk taking is derided ex ante, embarrassing when it failsGo long banks in winter 2009Going long banks in summer 2008A ‘bad’ risk is merely considered foolish, not

‘risk’Ask a businessman their biggest risk: a

successful contrary bet

Market makers (traders)Provide liquidity, manage riskPrivileged access to stale retail trades

Long Term Capital ManagementTrading WizardsDumb relative value trades

Short US vol vs European volLong US Swap spreadsLong RussiaPairs (Shell vs Royal Dutch, VW)

James Cramer’s 90s hedge fundDeft trades based on fundamentalsTrading shenanigans

Asset Liability CommitteesManage yield curve exposureSmooth earnings

Bank Economists, Stock AnalystsProvide insight on future pricesGenerate trade ideas

KMV Default ModelPredict default with special sauceSpecial sauce: ketchup and mayonnaise

Easy to say you have alpha, because it presumes a risk adjustment no one agrees uponRisk is essential for defining alphaRisk is indefinableSay ‘you manage risk’ is like saying ‘I have

alpha’

Alpha often easy once you see itDon’t think an idea is too simple to be good

You can still screw it up when its thereWithin organizations

Need low-cost accessSome ideas only work at scale, or in

complementMost ephemeralBig Alpha hard to sell

Then: index fundsNow: beta arbitrage, MVPs

0IQ

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